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Ratio analysis

Meaning of ratios Its a relationship between two variables, which are interrelated. e.g. Height and weight to diagnose the financial strength and weakness of a company

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On the basis of statement


Balance sheet ratios-it sets the relation ship between the items given in balance sheet e.g. Debt equity ratio , P/L a/c ratios. relationship between items of P/L a/c e.g. NP ratio, GP ratio Combined ratios relationship between one item of balance sheet and one item of P/L a/c. e.g. debtors turnover ratio, etc.

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Benefits of ratios

To help in decision making


Control Finding out the trend in the industry To know the competitive position

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Limitations With Ratio Analysis


Ignore price level changes Ignore , nature , establishment year , etc for comparison . Single ratios are not useful, it needs to be compared i.e. intra firm and inter firm Limitation of accounting data it is dependent on the data provided in financial statements and there window dressing is possible Ignore qualitative factors

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5 major types / categories are--1. 2. Liquidity/ short term solvency the ability of the firm to pay its way Investment/shareholders information to enable decisions to be made on the extent of the risk and the earning potential of a business investment Gearing/ long term solvency information on the relationship between the exposure of the business to loans as opposed to share capital Profitability how effective the firm is at generating profits given sales and or its capital assets Turnover /Financial/Activity the rate at which the company sells its stock and the efficiency with which it uses its assets

3. 4. 5.

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Liquidity

Current Ratio
Current ratio looks at the liquidity of the business

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Looks at the ratio between Current Assets and Current Liabilities Current Ratio = Current Assets : Current Liabilities Ideal level approx 1.5 : 1 or 2:1 Need enough current assets to cover current liabilities If its too high means too many current assets e.g. might have too much stock, could use the money tied up in current assets more effectively

If its too low you run the risk of not being able to meet current liabilities and you could have liquidity problems

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Acid Test
Acid test ratio is another way of looking at liquidity

It has been argued that stock takes a while to convert to cash so a more realistic ratio would ignore stock
(Current assets stock) : liabilities 1:1 seen as ideal

Again if it is too high means that the business is very liquid may be able to use the cash for other activities to increase performance
If it is too low then the business may face working capital problems Some types of business need more cash than others so acid test would be expected to be higher

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Absolute liquid ratio


It is represented by cash and near cash items

This ratio is
Cash+bank+marketeable securities liabilities liquid

Ideal ratio is .50 :1


Liquid liabilities mean current liabilities bank OD

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Gearing

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Gearing
This is an efficiency ratio Looks at the relationship between borrowing and fixed assets Gearing Ratio = Long term loans (fixed charges bearing funds)/ Capital employed (net Asset ) x 100 The higher it is the greater the risk the business is under if interest rates increase Net asset = total asset current liability

Debt equity ratio-

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Long term debts /long term funds (borrowed and owned funds) Or Long term debts/ Eq.shareholders fund

Ideal ratio is 1:2


Proprietary ratio-

Proprietors fund /total tangible assets


Higher is the ratio , higher is the solvency

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Profitability

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Profitability
Profitability measures look at how much profit the firm generates Profit is the number one objective of most firms Different measures of profit gross and net Gross profit total revenue variable costs (cost of sales) Net Profit Gross profit overheads

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Profitability
Gross profit looks at how much of the sales revenue is converted into profit Gross Profit Margin = Gross profit / turnover x 100 The higher the better Allows the firm to assess the impact of its sales and how much it cost to generate (produce) those sales A gross profit margin of 35% means that for every 1 of sales, the firm makes 35p in gross profit

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Profitability
Net profit looks at how much of the sales revenue is left as net profit
Net Profit Margin = Net Profit / Turnover x 100

Net profit is more important than gross profit for a business as all costs are included
A business would like to see that this ratio has improved over time

Profitability

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Another profitability ratio looks at operating profit and capital employed by the business Return on Capital Employed (ROCE) = Profit / capital employed x 100

Need to compare to previous years and competitors to get a clear picture


Can improve this by increasing profits without increasing fixed assets / capital

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Financial

Asset Turnover ratio

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Looks at a businesses sales compared to the assets used to generate the sales

Asset turnover = sales (turnover) / net assets


Net assets = Total assets current liabilities The value will vary with the type of business: Businesses with a high value of assets who have few sales will have a low asset turnover ratio If a business has a high sales and a low value of assets it will have a high asset turnover ratio Businesses can improve this by either increasing sales performance or getting rid of any additional assets

Stock turnover ratio


Another efficiency ratio

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Looks at how efficiently a company converts stock to sales Stock turnover ratio = cost of sales (COGS)/ avg. stock or Net sales /avg. inventory
High stock turnover means increased efficiency

However it depends on the type of business

Low stock turnover could mean poor customer satisfaction as people might not be buying the stock

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Debtors turnover ratio

Credit sales/ avg. debtors


High ratio mean quick conversion of debtor into cash

Low means liberal policy

Debtors collection period


This is another efficiency ratio

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This looks at how long it takes for the business to get back money it is owed Debtors collection ratio = Avg. debtors x 365 / turnover (credit sales )

The lower the figure the better as get cash more quickly
However sometimes need to offer credit terms to customers so this may increase it Need to ensure keep track of any changes in credit terms as these should impact this ratio

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Creditors turnover ratio

Net credit purchase / Avg. Accounts payable (cres.)


It signifies the credit period allowed by vendors / suppliers High means frequent payment (less interval )..low means (high interval )

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Creditors payment period

Avg. creditors x 365/net credit purchases


It signifies the time period .

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Investments/ shareholders

Investment/Shareholders

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Shareholders are interested in the following ratios: Dividends per share total dividends / number of shares issued A higher figure means the shareholder got a larger return Good to compare with competitors Businesses can improve this themselves by increasing dividend payments

Besides following are the other ratios Earning per share (EPS) EAITD/No. of equity share Higher is the ratio , higher is the return Price earning ratio Market price per Equity share /EPS A high ratio is preferred

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dividend payout ratio


Div per share/ Earning per share A high DP ratio is always better

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Some other ratios

Expenses ratio=expenses (factory/admin/selling/particular)/net sales


Operating ratio=total operating cost x100/sales Interest coverage ratio =EBIT/ interest

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